SECURITIES ANDEXCHANGE COMMISSION

Washington, D. C. 20549(202) 755-4846

HOLD FOR 6:00 P.M. RELEASE, TUESDAY, MARCH 19, 1974

DIFFERENTIAL DISCLOSURE: TO EACH HIS OWN

An Address By

A. A. Sommer, Jr., Commissioner

Securities and Exchange Commission

The Second Emanuel Saxe DistinguishedAccounting Lecture

Baruch CollegeNew York, New York

March 19, 1974

DIFFERENTIAL DISCLOSURE: TO EACH HIS OWN

A. A. Sommer ,Jr. *Commissioner

Securities and Exchange CommissionWashington, D. C.

On October 4, 1973, the Securities and Exchange Commission issued

Securities Act Release No. 5427 entitled somewhat innocuously, "Notice of Proposed

Amendments to Regulation S-X Providing for Disclosure of Significant

Accounting Policies." This release proposed for further comment proposedchanges in Regulation S-X which would require increased disclosure concerning

the consequences of an issuer opting for certain accounting principles in

preference to others.

The previous exposure for comment of these proposed changes had elicited

the sort of responses one might have expected. Generally, analysts endorsed

the thrust of the proposed changes and issuers endorsed the objectives but ex-

pressed concern about the particulars of implementation -- and it was to be expected

that the re-exposure would elicit another round of fairly technical comment

and suggestions.

However, Securities Act Release No. 5427 contained a section that

raised the debate from one over technicalities to one concerning fundamental

disclosure philosophy. This section was entitled "An Approach to Disclosure."

The first paragraph of this section said:

* The Securities and Exchange Commission, as a matter of policy, disclaimsresponsibility for any private publication or speech by any of its membersor employees. The views expressed here are my own and do not necessarilyreflect the views of the Commission or of my fellow Commissioners.

- 2 -

"The proposals set forth in this release are primarilydesigned to assist professional analysts who have theresponsibility of developing an understanding in depth

of corporate activity. They are not primarilyintended to serve the direct needs of the 'averageinvestor.' Such an investor does not usually havethe time to study or the training necessary tofully understand the data which are called forherein. It is not appropriate, however, for suchdata to be unavailable to the average investor whodoes wish to devote the time necessary to considerit. By being included in financial statementsfiled with the Commission, therefore, data will be-come 'data of public record' and, hence, availableto all. Disclosure will not be discriminatory eventhough usage will mostly be by professionals. Dataof this kind would not be expected to be sentroutinely to all shareholders, although it would beuseful if its availability was mentioned in communi-cations with shareholders and if management tooksteps to make it available on request."

This was the first indication, at least officially, by the

Commission that financial statements might be something other than unitary

that is, that there might be financial statements for the sophisticated in-

vestor and professional analyst and financial statements for the average

investor. This reminds me, I must confess, of the famous Bill Mauldin

cartoon during the Second World War which showed a brass-laden officer

watching a sunset asking his orderly, '~agnificent! Is there one for the

enlisted men?"

This development,reiterated in subsequent releases concerning income

taxes and compensating balances, quickly became a matter of extensive comment,

concern and criticism. I think it is fair to say that few, if any, voices

were raised in support or praise of the Commission~s innovation and, as is

not uncommon, the Commission found itself somewhat alone.

I would suggest that the new direction pointed by the Commission

is a step in the demytholigization, if I may call it that, of the disclosure

- 3 -

process; a step that in one way or another has been called for by eminent

commentators such as Homer Kripke, though I hasten to add that 1 am not sure

he and his fellow critics would particularly endorse the particular manner

in which the Commission is setting about accomplishing this demytholigization.

This effort recognizes and responds to such fundamentals, acknowledged by

all, as the fact that American business has grown steadily more complex, that such

complexity has been geometrically expanded by conglomerization and the ex-

panding multinational character of American enterprise, that increasingly

complex accounting rules have been necessitated by changes in the business

scene. It recognizes the rather fundamental fact that investors come in not

57 varieties, but more accurately, fifty-seven thousand and more varieties.

Some are astute as Warren Buffett of Omaha, Nebraska, whose exploits are amply

described in Supermoney; others are as naive as the legendary Aunt Jane in

Dubuque, Iowa. Some are assisted by professionals, but retain the final

judgment, which may reflect not only the astute analyses of those they pay

handsomely but other considerations as subjective and, if you will, irrational

as those that often animate horse players. Some have abandoned the individual

quest for investment success and have committed theis resources to professionals

who, hopefully,'have greater capacity to comprehend this swiftly changing, ever

more complex, business world and interpret it meaningfully and in a way that

leads to profits.

This is the world that the Securities and Exchange Commission,

Congressionally designated enforcer of broad standards of disclosure, de-

terminer of what should be disclosed and how it should be disclosed and how

it should be disseminated, confronts: a complex world in which just the

footnotes of the financial statements of a conglomerate -- described by one

commentator as "the most exciting part of the annual report" -- might run

- 4 -

a dozen or more pages, with perhaps other pages of notes following the finan-

cial statements of 'non-consolidated or separately reporting entities; a world

in which there are asserted to be some thirty million shareholders (a declining

number, incidentally), many of whom find it difficult to balance their checking

accounts, some of whom are as trained and knowledgeable ana astute as Mr. Buffett;

a world in which annual reports compete with television, Playboy (and now

Playgirl) and a multitude of other human activities and endeavors for the at-

tention of investors.

Manny Cohen, a former Chairman of the Commission, would often say

that he had difficulty explaining anything unless he went back to Genesis.

I don't propose to go back quite that far, but I do think it would be helpful

to go back to the genesis, small "gil if you Will, of the federal disclosure system,

the Securities Act of 1933.

Congress in 1933, confronted with indisputable evidence of massive

financial wrongdoing in the 1920's, and convinced that much of it stemmed

from the failure of promoters and entrepreneurs to fairly and candidly inform

those whose resources they gaJnered and used in their endeavors, adopted the

philosophy of the English Companies Act and mandated that those ~ho sought

money from the public through distributions of securities should, with narrow

exceptions, make comprehensive disclosure in connection with the distribution.

Prior to this mandate, multi-million dollar offerings of large and respected

companies were made with no more disclosure than could be put on a single sheet

of paper, and this disclosure often consisted of little more than an identifica-

tion of the issuer, the kind of securities involved in the issu~, and a few

financial facts.

- 5 -

Congress' hope, one that many think has proven to have been unduly

optimistic, was that disclosure would in time defeat the schemes of the

predators and restore the integrity of the financial markets. In Schedule A to the

1933 Act it specified the information prospectuses and registration statements

should contain and ~ave the Federal Trade Commission (supplanted in 1934 as

the monitor of the disclosure system by the newly created Securities and

Excha~ge Commission) broad powers to vary the requirements.

It was apparent from examining Schedule A that financial statements

of integrity loomed large in Congress' thinking. A prospectus was required to

include a balance sheet and income statement certified by independent public

or certified accountants and it was specified that such statements should show:.

n[A]ll the assets of the issuer, the nature and costthereof, whenever determinable, in such detail andin such form as the Commission shall prescribe • • • • All the liabilities of the issuer in such detail andsuch form as the Commission shall prescribe, includ-ing surplus of the issuer showing how and from whatsources such surplus was created ••• n

"[E]amings and income, the nature and source thereof,and the expenses and fixed charges in such detail andsuch form as the Commission shall prescribe • • • [W]hat the practice of the issuer has been • • • as tothe character of the charges, dividends or other dis-tributions made against its various surplus accounts,and as to depreciation, depletion, and maintenancecharges, in such detail and form as the Commissionshall prescribe, and if stock dividends or avails fromthe sale of rights have been credited to income, theyshall be shown separately with a statement of the basisupon which the credit if computed. Such statement shallalso differentiate between any recurring and nonrecurringincome and between any investment and operating income.n

- 6 -

The legislative history of the 1933 Act clearly showed thedetermination of Congress that financial statements be honest and reliable.At one time it was proposed that federal auditors certify the financial state-ments of publicly-held companies and only the avowals of the accountingprofession that it could supply the sought for reliability prevented thisdevelopment.

In 1934 Congress adopted the Securities Exchange Act of 1934 whichprovided the framework for a continuous disclosure system, including periodicreports to be filed with the Commission and disclosures to shareholders throughproxy statements by companies listed on exchanges. It should be noted that atthis time exchanges, principally the New York Stock Exchange, had been steadilyincreasing their pressure for listed companies to increase the quantum ofdisclosure to shareholders.

In the 1934 Act, perhaps largely because of the steps which hadbeen taken by exchanges, Congress did not specify in the detail it had in the 1933Act, the kinds of disclosure which should be made, but rather left to its

new creation, the SEC, the task of specifying such details.This scheme of disclosure, I suggest, reflected several assumptions

of varying merit. First, I think it suggested the assumption that investmentdecisions, not all perhaps, but certainly a sociologically significant number,

were made on a rational basis. This approach was reflected in Graham and Dodd's

first edition of Security Analysis published in 1934 which ushered in a new eraof fundamental investment analysis. It was believed that investors would -- andcould -- use the information provided, that they would thereby be impelled to

make sounder decisions, thus avoiding the fraud and overreachings characteristic

of the twenties.

- 7 -

I would suggest that perhaps underlying the Congressional commitmentto the disclosure philosophy was a far more basic assumption, one having itsroots deep in American history and ideology: the belief that the "commonman" had an innate wisdom, a natural capacity for the absorption of knowledge,an inborn facility for sound judgment jf only he had the facts. This is re-flected in many of our popular sayings; for instan~e, "let people know and thetruth shall make them free." It is reflected in our commitment to educationand the assumption, now perhaps discredited, that everyone has the capacityfor the fullness of a classical education. This ideology has its origins, ofcourse, in Rousseau and many others.

With these assumptions so entrenched, it is not surprising thatthere is little in the legislative history of the 1933 and 1934 Acts concern-the ~se that people might make of the information Congress wished them tohave, the manner in which investment decisions were made, the process bywhich judgments were reached. That the intervening four decades have done

little to change this situation is indicated in the Report of the Study Groupon the Objectives of Financial Statements in October 1973:

"Users' needs for information, however, are not knownwith any degree of certainty. No study has beenable to identify precisely the specific role finan-cial statements play in the economic decisionmaking process."

- 8 -

The natural consequence of the Congressional mandate for a disclosure

system, the assumption that investors are generally rational, the conclusion

that the quality of investment decisions is related to the quantity and

integrity of disclosure, and the belief that the "common man" has' uncommon'

wisdom and judgment, has been a constant pressure for increased disclosure:

more information, information ot higher reliability, broader dissemination.

This insistence upon more disclosure and more reliable disclosure

has been particularly pronounced with respect to financial information.

Through the years, to assure reliability, the Commission has steadily

tightened the mandate of auditor independence. There has been steady expan-

sion of the amount of disclosure. For instance, in 1971 the Commission required

a source and application of funds statement and in 1969 the Commission first

required disclosure of line of business profitability in 1933 Act prospectuses

and later extended this to periodic reports. One reads the list of the

Commission's Accounting Series Releases and can discern there the rising de-

mands for more and better information.

This expansiveness has been accompanied by rather constant controversy.

The business community, which is the source of the information, has repea red Iy

urg~ restraint for several reasons. It has contended that frequently the

Commission was indifferent to the costs involved in producing the additional

information; that the additional information was of questionable utility; that

analysts always want more without knowing what to do with what they had; that

additional disclosures would favor competitors at the expense of and to the

hardship of the enterprise~ shareholders. The Commission has often given

- 9 -

recognition to these contentions through what must fairly be described as

minor concessions, but the expansion of disclosure has gone forward

unremittingly.

While the controversies concerning the particulars of disclosure

have been fought through Commission releases, comments on them, articles in

the Financial Executive and Journal of Accountancy, a deeper and broader

controversy, which had for so long been hidden on the shelf, has been emerging.

In this controversy the issues are simple: does all this financial disclosure

mean anything? Has it a utility? Has it made a difference? Is the investor

better off because of all of this federally mandated disclosure?

The critics of the whole disclosure system have brought to bear on

the controversy techniques of analysis that are in some instances novel, at

least to the ears of the lawyers and accountants who have been the principal

custodians of the disclosure grails since 1933; among these has been sophisti-

cated mathematical analysis. In the forefront of these critics has been Professor

George Benston (popularized and encouraged by Professor Henry J. Manne) who has

written'that the disclosure requirements of the Securities Exchange Act of 1934

have had no measurable, positive effect on the securities traded on the New

York Stock Exchange, that there is little basis for the 1934 Act and no evidence

that it was needed or desirable, and that "certainly there is doubt that more

required disclosure is warranted." Professor Benston uses an empirical method of

analysis ,in an attempt to prove that the disclosures mandated by the 1934 Act

have not been effective in preventing fraud and manipulation. Professor Manne

has echoed this thought in Barron's:

- 10 -

I~S we approach the 40th Anniversary of the SecuritiesExchange Act of 1934, honorable men everywhere woulddo well to reevaluate the whole field of securitiesregulation. Instead of constantly repeating thedeadening cliches about fairness, disclosure and fraud,perhaps some brave Congressman or Senator or evenCommissioner of the SEC will take note of what compe-tent economic scholars are beginning to say about thefield. II

Critics of the Benston-Manne analysis have retorted that the

mathematical mode of analysis is not suited to the complexities of the

investment process, that within the parameters of their technique there

are insufficiencies, that disclosure serves purposes beyond that of simply

informing investors, that forty years of steadily stronger securities markets

in this country (recent aberrations excepted) provide some evidence of the

values of disclosure, that the propensity of other countries to emulate our

system indicates convictions of objective observers of the value of the

disclosure system.

And there are other more fundamental discussions that reach to the

heart of our disclosure system. Increasing attention is paid to the so-called

"random walk theory" which questions the utility of the Graham and Dodd kind

of fundamental analysis (as indicated above, a premise of the disclosure

system) by asserting that if an investor simply diversifies his risks he

will do as well as the investor who engaged in extensive research and analysis.

Without attempting extensive analysis of the pros and cons of these somewhat

exotic theories, it does strike me that the random walk theory is grounded

on notions of an efficient market, and an efficient market is one in which

all information of consequence is evenly and fully distributed; hence

I think even if one is a devotee of the random walk theory, there is the

necessity for an effective information dispensing system, otherwise the

fundamental of the theory, an efficient market, is impossible.

-11-

While these intriguing and potentially most significant discussionscontinue -- and I think they are extremely important and pose challengingand difficult problems for those responsible for securities regulation __there have been changes in the manner in which investment decisions aremade. For one thing, increasing amounts of investable funds are in the handsand under the control -- of institutions. In 1961 some 430 billion dollarswere under the control of institutions; in 1971 this amount had grown to839 billion, and by now the amount is surely near a trillion dollars. In 1961investment companies had 34 billion dollars under management; in 1973, evenconsidering heavy redemptions, the total was about 73 billion. Institutionaltrading currently accounts for approximately 70% of the volume of trading onthe NYSE. A further indication of the nature of this change is reflected inthe membership figures of the Financial Analysts Federation. At the end of1950, there were 2,422 members; there are currently approximately 14,000 members.Increasingly various financial institutions have offered money managementservices. Brokerage houses and banks are actively competing for such businessand frequently brokers state their preference for such activity over customarybrokerage services because of its reliability and persistence as a source ofrevenues. There is a constant lowering of the minimum portfolio which advisorswill undertake to manage. The growth of this activity was recognized in thereport of the Commission's Advisory Committee on Sma~ Business InvestmentManagement Services which, among other things, urged the Commission to forego tightregulation of so-called "mini-accounts," provided certain specified conditions

were met.Thus, the institutionalization of the market has been accompanied by

What I could call, for want of a better term, the quasi-institutionalization ofthe market -- the increasing reliance -- in many cases conclusive reliance --

- 12 -

of individual investors who retain the final decision with respect to invest-

ment decisions upon the advice of professionals.

Perhaps indicative of this increased emergence of quasi-institution-

alization of the market is the concern of the financial analysts themselves

for the quality of their performance and the integrity of their profession.

Several years ago the Financial Analysts Federation commenced a program of

study and qualification which would result in the encomium, "Certified

Financial Analyst," in the belief that sufficient public repute would attach

to the magic initials "C.F.A." that less reputable or competent analysts

would be driven from the market. While the program has resulted in the award

of this designation to about -3,000 analysts, it has not, in the minds of many,

been sufficient and there have recently arisen demands for more rigorous regu-

lation, either state or self-regulatory or federal with perhaps a measure of

self-regulation.

The disclosure system has resulted in the availability of tremendous

amounts of information for anyone who wishes to use it. Whenever an issuer

"goes public" for the first time it must file with the Commission a registra-

tion statement containing extensive financial and non-financial information

and much of that must, albeit for the most part at a somewhat insufficient

time before the final investment decision is made, find its way into the

hands of investors. Thereafter, until the number of its holders of equity

securities falls below certain minimal levels, it must file each quarter

with the Commission an abbreviated income statement, it must file annually

a Form 10-K which in effect updates its registration statement under the

~

- 13 -

1933 Act, it must file with the Commission promptly reports- of certain im-

portant events such as changes in debt terms that affect the rights of any

registered class of securities, it must furnish to shareholders annual

reports containing certified financial statements, and it must furnish proxy

materials in connection with proxy solicitations (and comparable informa-tion even if it doesn't solicit proxies). And increasingly there are pressures

from exchanges and courts for publicly-held companies to make prompt public dis-

closure of important developments, even though the legal theories relating to

such disclosure are in a state of development and not yet fully articulated.

All of this information, legally mandated, is of course supplemented

in many ways. There are analysts' meetings, increasingly subject to judicial.

mandates that important information provided at such meetings be given wide

circulation; there are the interpretations published by commentators; there<,

are the speeches of company officers. All of this adds to the fund of in-:.'formation, often approaching torrential proportions, available to the investor.

I think it would be naive -- and irresponsible -- if, having

achieved this vast outpouring of information and its relatively efficient

dissemination, we concluded that our task was done. That may have been the

conviction that animated Congress in 1933 and 1934, but I say we know more

about the limitations of human beings, we have somewhat more concise, albeit

still quite inexact, notions of how people invest, we have less Rousseauian

confidence in the competence of the common man, to reach that easy a conclusion.

All of the above has led critics of the present disclosure system

like Homer Kripke to criticize what he rather pungently calls "The Myth of

the Informed Layman." Professor Kripke said in his article bearing that

title:

..14 ..

"[T]he Commission has misconceived its market.It has never admitted any hypothesis other thanthat the prospectus is intended for the man inthe street, the unsophisticated lay investor.My theme is that the theory that the prospectuscan be and is used by the lay investor is a myth.It is largely responsible for the fact that thesecurities prospectus is fairly close toworthless."

In another article, Professor Kripke has said simply: I~y conclusion

is that the goal of financial accounting should be to provide the most useful

information for serious securities investors, financial analysts and money

managers who serve investors, and for economists."

His conclusion, and that of others, is that we should do away

with the nonsense of trying to make prospectuses and other disclosure docu-

ments simple and understandable for the layman (it is a prerequisite under

Rule 460 that a prospectus be reasonably concise and readable so as to

facilitate an understanding of the information contained in the prospectus

and periodically the Commission urges issuers to make their documents more

readily understandable) and recognize that the only ones able today to cope

with the complexities of American business and the concomitant complexities

of disclosure about American business are the sophisticated, knowledgeable,

informed professionals to whom the non-professionals increasingly turn for

help in making their investment decisions.

This approach has much appeal. The Commission could multiply the

requirements of disclosure with no concern for easy comprehensibility; it

would be possible, for instance, to perhaps mandate new kinds of mathematical

and economic disclosure, including sophisticated projections and other forward

looking information, which would mystify the average investor but make sense

to the trained analyst familiar with sophisticated research methodology.

C~rtainly an express abandonment of the small investor would open the door for

f a r more sophisticated disc losure techniques.

- 15 -

And yet there lingers the mythos and the fact: the mythos, thatAmericans can make up their own minds, that they have a competence to decide

their own political fate and fortiori their financial fate; the fact that,notwithstanding the increasing dependence upon professionals, there arestill many investors who do make their own decisions, who do try to copewith the data provided to them, who are unwilling to surrender their judgment.And there is the fact that often we hear of such investors who regularlyoutperfo~ the professionals despite their apparently limited expertise.

This "common man" concept has been expressed repeatedly in Commissionrules and determinations and court decisions relating to standards ofmateriality. For instance, Rule 405 of the Commission defines materiality as

"those matters as to which an average prudent investor is reasonably to beinfoI'llledbefore purchasing the security registered."

Similarly, in SEC v. Texas Gulf Sulphur Co. the Court of Appeals

for the Second Circuit used as one of its criteria of materiality this:"[Wlhether a reasonable man would attach importance

• • • in determining his choice of action in thetransaction in question • • ."

The standard of materiality is thus that which means something to

the "ordinary prudent investor" -- not the expert, but the ordinary prudentinvestor. This notion has been aUnost reduced to a statistical criterion.

In Feit v. Leasco Data Processing Equipment Corp. , Judge Weinstein, in-speaking of materiality, said:

"A fair summary of the rules stated in terms ofprobability is that a fact is proved to bematerial when it is more probable than not thata significant number of traders would have wantedto know it before deciding to deal in the securityat the time and price in question • • ."

-- I

~

- 16 -

The varying purposes of and audiences for disclosure have not gone

unrecognized. In the Commission's "Disclosure Policy Study" (the "Whea~ Report")

it was said:

"By and large, the Commission has responded to thevarious needs for disclosure in pragmatic fashion.Thus, where an issue of securities possessed un-usually speculative elements, it was felt thatspecial efforts should be made to call these factorsto the attention of the ordinary investor -- hencethe development of the 'introductory statement' tothe prospectus. By contrast, the detailed financialinformation required by the schedules to the Form .IO-K report could be intended only for the skillfulanalyst. Indeed, it was recognized from the begin-ning that a fully effective disclosure policy wouldrequire the reporting of complicated business factsthat would have little meaning for the average in-vestor. Such disclosures reach average investorsthrough a process of filtration in which intermedi~aries (brokers, bankers, investment advisers,publishers of investment advisory literature, andoccasionally lawyers) playa vital role."

In an article recently published by the Hastings Law Journal, Alison

Gray Anderson has perceptively described the efforts of the Commission to both

protect the small investor and serve the needs of the professional and the

sophisticated investor, and suggests that perhaps the Commission is today

according less primacy to the protective role.

Given this background, it is rather surprising that the idea that there

should be "differential disclosure" has met with such dismay and dissent. After a

in matters of news we are accustomed to "differential disclosure." The maq

who wants simply, shall I say, notification watches the eleven o'clock news;

the one who wants more, say enough to handle a conversation on current events

intelligently after a couple of martinis at a cocktail party, reads Time or

Newsweek; the person seeking perhaps more detail an~ some interpretation goes

- 17 -

to the New York Times or the Washington Post; while the real student reads the

Congressional Record, official releases of governmental agencies, and the myriad

of other materials available.

There are as many capacities to understand and cope with information,

and willingness and desire to do so, perhaps as there are investors; conse-

quently, it is impossible to design a single disclosure system that perfectly

matches the needs and capacities of each person. Consequently, as in most

things in life, we must categorize, recognizing that the fit will be crude in

most cases, but better than the kind of procrustean achievement that would

dictate a single set of requirements for everyone simply on the grounds,

somewhat Steinian, that an investor is an investor is an investor.

Once one concludes that a disclosure system should at least be

bifurcated, if not refined more precisely, then I think the problem is much

more complex than simply quantity. It is not enough to say simply, '~ow

that we recognize that the skilled professional can use well more

sophisticated information than the amateurs we will simply give him moreinformation." There is at the minimum a correlative necessity to process

and prepare the information for use by the "average" investor (to use a

wholly inadequate term) in a manner that will make it useable and useful;

it is a matter of presentation, as well as quantity. There is also the

problem where and how the respective disclosures are made. If that directed

to the professional is so interlaced with that intended for the amateur,

then it may well have the effect of causing the unsophisticated investor

to back off in fear and confusion. Attention must be paid to the fact that

professionals have access to information that would not be available to the

- 18 -

small investor; for instance, analysts frequently seek out filings with theCommission -- in many cases they receive "microfiche" copies routinely, whilesmall investors would hardly know where to begin in seeking out this information,although the Commission's recent proposal that corporations make the Form 10-Kavailable on request is designed to partially remedy this problem. Thus thereare problems of mode of presentation and dissemination as well as those ofquantity and complexity of information that must be faced.

Undoubtedly the part of the Commission's approach to differentialdisclosure which has troubled most, particularly those in the accountingprofession, is the requirement of the Commission that this differentialdisclosure be accomplished through the financial statements of the enterprise.

Securities Act Release No. 5427 indicated that the extensive additional in-

formation which would be required by the proposed amendment of Rule 3-08 ofRegulation S-X should be a part of the financial statements filed with theCommission but would not necessarily have to be part of the financial state-ments furnished to investors at large. The release said, "By being includedin financial statements filed with the Commission data will become

'data of public record' and, hence, available to alL" The same concept

is embodied in Accounting Series Release No. 148. In Accounting SeriesRelease No. 149 pertaining to income tax expense the distinction is most

clearly indicated:"The Commission has concluded that the benefits of

the disclosure are sufficient to require itspresentation in financial statements filed withthe Commission but it recognizes that the detaileddisclosure required herein will be primarily ofinterest to professional analysts • • • and may notbe required in financial statements designed for theaverage investor • • ."

•

- 19 -

Two facets of this concept trouble accountants. First, the term"financial statements" has traditionally had a unitary connotation; thereis one set of numbers and notes that constitutes the financial statementsof the enterprise; the notion that there should be two or more financialstatements is alien. It might be noted that there is, in a differentcontext, increasing suggestion that there may be the necessity for morethan one set of financial statements to properly convey necessary financialinformation concerning an enterprise. In a paper prepared for the Tenth

International Congress of Accountants, Robert Trueblood said,"Today, however, many more groups are expressing

a need for enterprise financial information.And, as always, users of financial statementsask for more information, in more depth. Theinterests of different user groups vary somewhat,and their information needs sometimes conflict.General purpose financial statements simply can-not be expanded to cover all legitimate informa-tion requirements.

"To meet the diverse information requirements ofall those who have a legitimate need for enter-prise information, a new reporting method mustbe developed. The core-statement satellite-report concept is a suggested solution.

"The core statement would present financial position,net earnings, and equity status -- as those termsare understood in an economic sense. Ultimately,the core statement would be accepted as the commondenominator, by all users, in all countries. Theinformation needs of particular user groups wouldbe served with satellite reports, tailored to theirspecific needs."

This is hardly a new idea. George O. May, one of the giants of theaccounting profession, as long ago as 1937 suggested that a single set of

statements could no more serve the diverse needs of investors than a single

- 20 -

utensil could satisfy the need of table silver. He expressed the notion in

an article appropriately entitled, "Eating Peas with Your Knife," in which he

discussed

"the inefficiency, if not the danger, entailed inthe use of accounts for purposes for which theywere not designed, and for which they are notappropriate ••• [I]t should be obvious that itis not possible to get one form of account or onestatement which will serve equally well the purposesof regulation, taxation, annual reporting and asecurity issue. Yet this does not seem to be at allgenerally appreciated."

The second concern of auditors derives from concern over leaving

out of financial statements on which they issue an opinion information and

data which at least some investors consider important. Is this inconsistent•with the opinion that the statements have been prepared in accordance with

generally accepted accounting principles? It is fundamental -- and so ex-

pressed in accounting literature -- that certified financial statements may

not omit anything material to the fair presentation of the information. Do

financial statements omitting the information which would be required in filed

financial statements by the proposed revisions of Rule 3-08 and the information

now required by Accounting Series Releases Nos. 147 and,l48 "present fairly"

in accordance with generally accepted accounting principles?

I will frankly confess these are genuine conce~ns expressed by

the accounting profession and they are deserving,of careful and close

analysis. The concerns of the profession are, of course, compounded by the

increasing incidence of litigation involving members of the profession and

the still expanding limits of Rule IOb-5, which, among other provisions, makes

it a violation of the Rule to omit anything necessary to make statements

made not misleading.

- 21 -

Of course, differences between the financial information filedwith the Commission in a Form lO-K and th~t furnished to shareholders isnot completely without precedent. Rule 14a-3 provides that certain of theparticulars contained in Form lO-K financial statements may be summarizedor omitted in those contained in the annual report and it is quite commonto do this. Furthermore, there is no explicit requirement that the financialstatements contained in the Form lO-K be the same as those in the annualreport, although Rule l4a-3 under the 1934 Act does require in the event ofdivergence explanation of the reason for it. Also there are required in theForm lO-K certain technical compliance notes (e.g., concerning stock options)which generally do not appear in the financial statements in reports to share-holders. And Form lO-K, as well as part II of the most used registration formsunder the 1933 Act, requires the filing of schedules which are covered by theauditor's report in addition to the financial statements.

I would suggest that the concerns of the accounting profession are

perhaps needlessly grave.First, any omission of information which is identified by the

Commission as necessary in filed statements but not in those circulated tothe investors in general would be in reliance upon Commission rule. Section23(a) of the 1934 Act provides: "No provision of this title imposing anyliability shall apply to any act done or omitted in good faith in conformitywith any rule or regulation of the Commission." Thus I think the liability

- 22 -

concern should be abated. Further than that, the Commission in Section 13(b)

of the 1934 Act is given the power to prescribe:

"[I]n regard to reports made pursuant to this title,the form or forms in which the required informationshall be set forth, the items or details to be shownin the balance sheet and the earning statement, andthe methods to be followed in the preparation of re-ports, in the appraisal or valuation of assets andliabilities, in the determination of depreciationand depletion, in the differentiation of recurringand nonrecurring income, to the differentiation ofinvestment and operating income ••• "

That the inclusion of the additional information in filings with

the Commission is pursuant to Commission rule is clear; that such informa-

tion may be omitted from the financial statements in annual reports is less

clear. However, the explicit permission in Rule 14a-3 to "omit such details

or employ such condensation as may be deemed suitable to management", combined

with the clear benediction of the Commission for the omission of such informa-

tion, would seem clearly to insulate auditors from liability. If there remain,

however, doubts of this, then perhaps the Commission should remove the un-

certainty through the rule-making process.

While the Commission has traditionally deferred to the accounting

profession with respect to the orderly development of accounting principles,

nonetheless it has been fully recognized through the years that the Commission

has broad power over the contents of financial statements and it has on

occasions, such as accounting for the investment credit, exercised that power

when it felt it necessary to do so. If the Commission has the power to

determine the content of financial statements, then I would suggest that

it has the power to classify financial statements and determine that

- 23 -

financial statements used for this purpose have such and such contents,

but that other financial statements intended for a different audience or use

have other or additional contents. And again, the Commission having made

such a determination, and an auditor having relied upon such determination

by the Commission, it is difficult to see wherein the danger of liabilitylies.

Apart from narrow legal considerations such as those discussed

above, does the mandating of additional information in financial statements

filed with the Commission do a wrong to the small investor -- is he misled ,is he denied' information which he is entitled to have?

I would suggest he is not. At the present time the accounting

process consists of summarization, judicious omission, careful selection of

items which are of use to those using financial statements; certainly no

one would suggest that there should be furnished to anyone outside a

corporation the full financial data that is available, e.g., the amount of

each receivable, each payable, the particulars concerning each category of

inventory, and so on. The entire process of financial presentation is founded

upon selection, summarization, condensation. Conventionally this is done

according to prescribed standards which have their roots in deeper principles

founded on assumptions -- concerning what information is useful to the users

of financial statements. The profession has just engaged in a most challenging

study of this entire matter in an effort to find what information is useful

to users of financial statements. Until that report is fleshed out, the

profession will continue to use the conventional standards embodied in

generally accepted accounting principles as presently articulated.

- 24 -

Those standards of presentation, I submit, are founded uponassumptions with regard to the identity of users. I would suggest that thoseassumptions are not sacred, or embedded in stone, or engraved on bronze. Allthat differential disclosure is suggesting is that there be explicit recognitionof the fact that implicit in the standards governing presentations areassumptions concerning users and that there be developed a further recognitionthat among those users are many who have need for and ability to use effectivelythis additional information.

A necessary correlative of expanding the detailed informationavailable to the professional and the skilled investor is the necessity ofmore and better summarization of data and sounder interpretation of it bymanagement. The interpretation of financial data is a complex business inwhich relatively few investors are skilled. The best source of meaningful

interpretation of data is management. As a consequent the Commission hasincreasingly required that the documents furnished to or made available toinvestors contain interpretations of the data presented; financial disclosureshould not be a contest between management and owners of the enterprise tosee whether the investor can uncover the significance of the raw figures.

For many years, for instance, the Commission has included in the instructionsto the use of Form 5-1 a requirement that:

lItflhe :information set forth in the prospectus should bepresented in clear, concise, understandable fashion."The Commission articulated this increased concern with ~derstandable

presentation to the small investor in Securities Act Release No. 5427 underthe same heading where the needs of sophisticated investors are discussed:

- 25 -

"While analysts' requirements are of great importance,the needs of individual investor must also be served.If this investor is to remain an active participantin the securities markets, he must be confident thathe is receiving data in a fashion which he can under-stand and which does not mislead him as to the opera-tions or position of the firm. He should not bepresumed to possess a depth of accounting or analyticalknowledge in order to obtain a reasonable picture of theresults of an enterprise's activities. The needs of theaverage investor can only be met by developing a betterprocess of analytical summarization where informationshown in detail in financial statements is selectivelypresented in an interpretive fashion so that the mostsignificant elements are highlighted in relativelysimple form. Since those elements which are most sig-nificant vary from enterprise to enterprise and fromperiod to period, no fixed rules can be established asto the specific elements to be included in such ananalytical summarization."

In proposed Guide 22 pertaining to 1933 Act filings, which would

also become Guide 1 with respect to 1934 Act filings, the Commission stated:

"Securities Act Guide 22 and Exchange Act Guide 1, ifamended and adopted as proposed herein, would requirean introductory narrative explanation of the Summaryof Earnings and Summary of Operations whenever clari-fication is needed to enable investors to appraisethe quality of earnings. Investors should understandthe extent to which accounting changes, as well aschanges in business activity, have affected the com-parability of year to year data and should be in aposition to assess the source and probability of re-currence of net income (or loss). Thus, wheneverthere are material changes in the amount and sourceof revenues and expenses, including tax expenses, orchanges in accounting principles or methods or theirapplication that have a material effect on net income,or if whenever management believes that historicalearnings are not indicative of present or futureearnings, an appropriate analysis and explanationwould be required."

- 26 -

As a further indication of the dynamics of the process of

determining which information should be available where and to whom, the

Commission has proposed to transport large segments of information hereto-

fore previously contained only in filings with the Commission into the

annual reports circulated to shareholders, including preeminently the in-

formation concerning the sales and profitability of lines of business. WithI

the continuing diversity of American enterprise, the Commission concluded

that this information is material to a larger group than simply those who

have ready access and opportunity to use the filings with the Commission and

hence should be available more readily in the investment market place.

Do these developing practices favor the professional investor and

the analysts' clients over the average investor? The easy answer, of course,

is that the information will be available for anyone who wants to extract

it from the Commission's files; but that is too glib. The fact is, of course,

that the professional investor and the analysts' clients have significant

advantages now deriving from their skills, their access.to publications

interpreting data, their ability to secure quite legally background informa-

tion from management through interviews and attendance at analysts' meetings;

there is no way that the Commission, or Congress for that matter, can

legislate or mandate equality of wisdom and skill among investors.

But even that, I would suggest, is too easy an answer. The fact

is that the Commission believes that this program will not enhance the

advantage of the professional, substantial as it is now, but will in the

final analysis give the small investor a better shot at knowledgeable

- 27 -

investment than he has now. I would emphasize that fully as importantS part of this approach as the increase in data filed with the Commission

is the requirement for better summarization of data and management analysis.These requirements witl afford the investor access to more of the kinds ofinformation with which he can deal most effectively. It will hopefully

lead him away from simplistic analyses centered on earnings or cash flowper share and into deeper awareness of the complexity of enterprise and theinvestment process.

If it has the collateral effect of pressing more investors into theoffices of the professionals, I would suggest that is not a bad resulteither -- provided the Congress, the Commission and the profession combine

to develop an adequate program to exclude from the ranks of professionalanalysts those lacking integrity or expertise. More and more Americans arerealizing that the investment process is hazardous, uncertain, and, likesurgery or trial advocacy, demands more than ordinary intelligence. To theextent that these advances by the Commission give better tools to theanalysts in their work, I would suggest all investors are the beneficiaries.

In summary, I would suggest that "differential disclosure" is a

new tool, with roots firmly in the past as well as in a greater present per-ceptiveness concerning the investment process and the nature of investors, bywhich the disclosure process can become more useful and more meaningful to

investors and their advisors. It recognizes the capacity of many to dealwith complexity and the inability of still others, who nonetheless areessential to the investment process, to match the formers' skills and expertise,

•

•

- 28 -

but who nonetheless must be the beneficiaries of the process if we are not toabort and abandon the purposes of the Congress in enacting the scheme of federal

securities laws which we have. Like any experiment, we must watch caref~llyits workings and assess realistically its a~hievements and failures. I believeit will succeed •